Accounting for financial instruments

A significant challenge for all entities adopting new Irish GAAP (FRS 102)

Michelle Byrne discusses the two dramatic areas of change as a result of adopting FRS 102, being accounting for loans with a fixed repayment date, and derivatives, which are complex financial instruments that a significant number of entities hold.

There are substantial changes likely for entities adopting FRS 102 ‘The Financial Reporting Standard applicable in the UK and Republic of Ireland’, particularly for entities transitioning from old Irish GAAP, the majority of whom did not previously elect to adopt the old Irish GAAP standard on financial instruments (FRS 26). So, for most reporters, two dramatic areas of change are the accounting for loans, with a fixed repayment date, and derivatives, which are complex financial instruments that a significant number of entities hold. This article will focus on specifically addressing these two areas.

For those reporters adopting Sections 11 & 12 of FRS 102 for their recognition and measurement of financial instruments, financial instruments are classified into two categories Basic financial instruments and other financial instruments.

Basic financial instruments are those within the scope of Section 11. Examples include (but are not limited to):

• Cash

• Trade and other receivables

• Trade and other payables

• Company borrowings; intercompany and external

Other financial instruments i.e. “non-basic” financial instruments which are generally more complex are within the scope of Section 12; examples include (but are not limited to):

• Derivatives e.g. forward contracts, interest rate swaps

• Convertible debt

• Warrants

• Options

The rules in FRS 102 for deciding whether a financial instrument is basic or other can be complex to apply in practice. Loans that are basic are generally to be accounted for at amortised costs; in contrast loans that have terms or conditions that do not meet the standards rules for basic are required to be at fair value.

1) Basic Loans

Under old Irish GAAP (FRS 4) the accounting was relatively straightforward. On initial recognition, the loan booked at the amount of the net proceeds (fair value of consideration less issue costs). The finance costs of the debt were allocated to periods over the term of the debt at a constant rate based on the carrying amount.

Under FRS 102 the accounting treatment is dependent on the terms and conditions of the loan and in particular on whether it has a fixed maturity or is repayable on demand. The following examples aim to illustrate this further.

Background:

• Parent advances €100,000, interest free, to subsidiary in year 1

• The market rate of interest is 5% (i.e. the rate that would prevail had the transaction been carried out with market participants at arms’ length)

• No transaction costs

• No embedded derivatives attached to the loan (i.e. no non-basic financial instruments included in the terms and conditions.)

Scenario 1: Fixed loan repayment date: 5 years

Initial recognition: present value (“PV”) of the cash flows using a market rate of interest

PV of €100,000 in 5 years using the market rate of interest (5%) is €78,350 (i.e. 1/(1+R)^n (where ‘R’ is the interest rate and ‘n’ the number of years). The difference of €21,650 in economic substance reflects the interest income foregone by the parent.

As this is an opportunity cost rather than an actual cost it does not meet the definition of an item to be recognised in profit or loss and accordingly is treated as a capital contribution by the parent to the subsidiary. Therefore this is recorded as a capital contribution in the books of the subsidiary i.e. within the equity section of the balance sheet and as an investment in subsidiary in the books of the parent. The intercompany payable/receivable will be classified as due in more than one year until the end of year 4 when the amount will fall due within one year and therefore will be classified into current assets/liabilities.

Notwithstanding that the loan is interest free there are entries to be made each year to record the effective interest which is in contrast to the accounting under FRS 4. The amortised cost of the loan is calculated on an annual basis on the carrying amount of the loan (principle and interest) using the effective interest rate method. The interest, as calculated, is credited to the profit and loss account annually in the books of the parent as finance income and charged to the profit and loss account annually in the books of the subsidiary as a finance cost.

It is also important to note that the cost of the investment in subsidiary will only reduce on either a sale or impairment of the investment in the subsidiary; and the capital contribution remains in the subsidiary’s equity until the directors resolve to make a transfer from this reserve.

Scenario 2: Repayable on demand

The entries for both the parent and the subsidiary under FRS 102 are the exact same as the entries under FRS 4 i.e. as loan is repayable on demand, the PV of a financial asset or financial liability payable on demand is discounted from the earliest date it can be demanded. In this example, the PV reflecting the ‘demand’ feature is the same as the cash amount borrowed.

Where there is no difference between the initial carrying amount of the loan and the amount repayable, the effective interest rate is equal to the contractual interest rate, which is zero. Consequently there are no entries to be made in years 1 to 5 as regards any finance income or cost.

2) Derivatives

A derivative is a financial instrument or other contract with all three of the following characteristics:

(a) Its value changes in response to the change in specified underlying variable;

A manufacturing entity trades significantly with the U.K. enters into a forward contract to purchase sterling due to the volatility in the foreign currency rates. To cover their exposure to exchange rate fluctuations, the company enters into a forward contract at £0.75:€1, to purchase £450k for €600k in six months’ time.

Previously, this derivative would have been disclosed in the notes to the financial statements, however, under FRS 102, it is required to be measured at its fair value and put on the balance sheet as either a financial asset or a liability (depending on whether it is in or out of the money). Any change in fair value from one period to the next results in a gain or loss recognised through the profit and loss account, resulting in volatility and potential tax effects.

Reporting entities will also need to consider the knock on effect which these accounting changes have on tax and other areas of their business e.g. systems and reporting, impact on banking covenants etc.

In summary, a successful transition to FRS 102 will inevitably require some effort. Specifically, accounting for financial instruments will need to be a key area of focus for almost all entities especially in respect of loans with a fixed maturity and derivatives.

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Director - Financial Reporting Advisory

Michelle is a director in our financial reporting advisory team. She currently advises clients on key accounting matters, under both IFRS and Irish GAAP. She manages specialist assignments and her exp... More

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